How a Home Equity Loan Works
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HELOC vs Home Equity Loan - Which Option is Right for You?
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Michael Jensen, Mortgage and Finance Guru
Updated February 24, 2022
Home Equity Line of Credit Overview
A home equity line of credit, also known as a HELOC, is similar to a home equity loan except that instead of borrowing a set amount of money when you put the loan in place the borrower is able to borrow money from, or draw down, the line of credit as needed. For example, a borrower may obtain a $50,000 HELOC but initially only draw down $10,000, which gives the borrower $40,000 in remaining borrowing capacity. Additionally, the borrower can pay off and draw down the line of credit up to the maximum line amount, an unlimited number of times. The borrower can draw $50,000 from the HELOC in the second year, pay back $15,000 in year three and then draw $15,000 from the line in the fourth year.
The monthly payment on a HELOC is typically lower than the payment on a home equity loan, especially if you are only paying interest on the line of credit
Just like a home equity loan, a HELOC is a second mortgage taken out on a property that uses the existing equity in the property as collateral for the loan. Borrowers can use the proceeds from a HELOC for numerous purposes including home remodeling or renovation, paying off high interest rate credit card debt or buying a second home or investment property. Borrowers use home equity lines of credit because it enables them to access the cash in their properties without refinancing their first mortgages which can be significantly more expensive and take a lot of time. Additionally, HELOCs enable you to borrow and pay interest on only the amount of money you need at any given time, which can make it less expensive, more flexible and more attractive financially than a home equity loan.
The home equity line of credit is subordinate, or junior, to the first mortgage on the property. In the event of a default or foreclosure, the holder of the first mortgage is paid off first before the holder of the HELOC. You typically do not need to get approval from your first mortgage lender to put in place a home equity line of credit but you should review your mortgage note to make sure that there is no acceleration clause that makes the first mortgage payable in full if the you put a second mortgage, such as a HELOC in place.
Types of HELOC
There are three primary types of HELOCs: fixed rate, adjustable rate and interest only. For all HELOCs, your monthly payment is calculated based on your interest rate and outstanding loan balance. While your loan balance depends on how much you have drawn down the line, your interest rate depends on they type of HELOC you have. We explain how each type works below.
Fixed Rate
- A fixed rate HELOC charges a set rate after the introductory or teaser rate expires. For example, you may pay a 2% for the first six months or year of the line and then 5% for the remainder of the line. Although your rate increases after the introductory period it is fixed at the new, higher rate and not subject to change.
Adjustable (or Variable) Rate
- With an adjustable rate (also known as a variable rate) HELOC the after introductory period interest rate is subject to change, and potentially increase, on a monthly, semi-annual or annual basis and fluctuates based on changes in an underlying index rate such as a treasury note or the prime interest rate. Some lenders offer a 5/5 home equity line of credit with the interest rate subject to change only every five years. 5/5 home equity lines typically require lower combined loan-to-value (CLTV) ratios.
- Monthly payments for an adjustable rate home equity line are based on the outstanding loan amount and are comprised of both interest and principal, which means you pay down the loan balance a little with every payment. Some adjustable rate home equity lines allow borrowers to convert all or part of their loan balance into a fixed rate loan, also called a fixed rate advance, which eliminates the risk that the interest rate and monthly payment will increase in the future.
Interest Only
- An interest only home equity line of credit is similar to the adjustable rate line of credit because the interest rate is subject to change on a monthly, semi-annual or annual basis and fluctuates with changes in an underlying index rate. With an interest only line of credit, however, the monthly payment is comprised of only interest and no principal during the draw period which means your monthly payment does not reduce your loan balance. The interest only option may only be available on owner-occupied properties.
- An interest only HELOC usually starts to amortize at a specified point over the course of the line, such as after ten or fifteen years although in some rare cases they permit borrowers to make a balloon payment at the end of the line to pay off the outstanding loan balance in its entirety.
How a HELOC Works
A home equity line of credit is are typically broken into a draw period and a repayment period. Most lines are structured as 20 or 30 year loans with a 10 year draw period. In the case of a 30 year HELOC with a 10 year draw period, after 10 years and one month the borrower can no longer draw down the line and is required to pay off the outstanding loan balance over the 20 year repayment period. So after 10 years the HELOC essentially becomes a 20 year amortizing loan. At the end of year 30, the loan balance is paid in full. Please note that some interest only HELOCs require a balloon payment at the end of the loan although this is relatively uncommon. The table below outlines the key loan terms for a HELOC.
Draw Period
- The draw period is a set period of time during which the borrower can withdraw funds from the home equity line of credit. The draw period is typically ten years plus one month. The interest rate for the draw period is typically adjustable.
Minimum Initial Draw Amount
- Also known as an initial advance, This is the draw amount you are required to have outstanding when your HELOC closes. So if the minimum initial draw is $10,000, you receive that amount in loan proceeds on day one of your HELOC. Not all HELOCs have minimum initial draw amounts but many do.
Minimum Loan Amount
- Some HELOCs require that you have a minimum outstanding loan balance at all times. If your loan balance falls below the minimum requirement you may be charged fees.
Maximum Loan Amount
- This is the maximum amount you can borrow under the terms of the HELOC. The maximum loan amount is determined based on your property value, how much equity you have in your property, CLTV ratio and other factors.
Repayment Period
- During the repayment period the borrower can no longer access funds with the line of credit and is required to pay down the outstanding loan balance. The repayment period is typically 10 - 20 years. The monthly payment during this time period is based on the interest rate and outstanding loan balance at the end of year 10. Depending on what type of line of credit you have, the interest rate for the repayment period may be adjustable (same as during the draw period) or fixed. If you have an interest only line of credit, your monthly payment may increase at this time because you are required to pay both interest and principal.
Balloon Payment
- Some interest only lines of credit do not have a repayment period and instead have a balloon payment at the end of the loan term when the borrower is required to pay the outstanding loan balance in full with a single payment. For example, for a 15 year interest only equity line of credit with an ending loan balance of $45,000, the borrower is required to make a $45,000 payment at the end of year 15.
- Borrowers can always pay down the loan balance over time before the balloon payment is due to avoid having to make one very large payment at the end of the loan. Borrowers should make sure they fully understand the risks associated with any loan with a balloon payment feature.
HELOC Rates
Most HELOCs offer a low introductory period interest rate for the first month to one year of the line which is also known as teaser rate. The introductory period rateis lower than the current market rate for a first mortgage. You may be required to take a minimum initial draw -- also known as an advance -- when the HELOC closes and maintain a minimum loan balance for a certain period of time to be eligible for the lower introductory rate.
When the introductory or teaser period expires, you are required to pay the after introductory period rate which is significantly higher than the initial rate. For example, the after introductory period rate may be 2.000% to 3.000% higher than the teaser rate, which means your monthly HELOC payment may increase significantly depending on your loan balance. The after introductory period rate may be fixed or adjustable depending on the type of HELOC you have.
The interest rate for an adjustable rate HELOC is based on an underlying index rate, such as a treasury note or prime interest rate, plus a fixed margin of 0% to 3.25%. The index plus the margin equals the interest rate you pay on the line. Some lines of credit have a minimum floor interest rate that your rate cannot fall below even if the index rate plus the margin is less than the floor rate.
If you have an adjustable rate HELOC, the interest rate during the draw period period adjusts monthly (most common), semi-annually, annually or every five years and fluctuates based on changes in the index rate. The interest rate typically remains adjustable, or variable, for both the draw period and repayment period but in some cases the rate becomes fixed for the repayment period, based on a formula determined at the time you obtain the HELOC.
The interest rate for HELOCs with a combined loan-value (CLTV) ratio ratio above 80% can be 0.5% - 1.0% higher than the rate on a line with a CLTV ratio below 80%. Additionally, the interest rate on lines for non-owner occupied properties can be .75% - 1.25% higher than the rate on owner occupied properties and the lender may also limit the loan term.
The after introductory period interest rate for a HELOC is typically 0.250% - 1.250% lower than the rate on a home equity loan, depending on the CLTV ratio, property type and loan term
The closing costs for a home equity line of credit are usually significantly lower than for a mortgage refinance. Lenders typically charge a processing fee and and the borrower is also required to pay third party closing costs such as the appraisal report fee. In some cases lenders rebate certain closing costs or offer lower rates if you open an account or set up autopay so be sure to ask about potential discounts when you shop for a HELOC.
HELOC rates vary by lender and market conditions. Lenders that offer home equity lines include banks, credit unions and mortgage bankers with credit unions offering especially attractive terms. The table below shows interest rates, monthly payments and loan terms for HELOC lenders near you. We recommend that you compare loan proposals for at least four lenders to find the HELOC that is right for you.
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Current Home Equity Loan Rates as of January 11, 2024
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Data provided by Brown Bag Marketing, Inc. Payments do not include amounts for taxes and insurance premiums. The actual payment obligation will be greater if taxes and insurance are included. Click for more information on rates and product details.
